Five key questions about the US interest rate rise

17th March 2017

A. J Bell’s investment direction Russ Mould considers the implications of the third 0.25% interest rate hike from the US Federal Reserve. He looks at the five key questions, all of which have implications for the US and global economies and therefore investment portfolios

1) What degree of interest rate increase has historically been needed to stop US stocks in their bull-market tracks?

“The quarter point increase in US interest rates was widely anticipated and hence priced in by markets. Although history shows that a third rate hike in a cycle can lead to a stock market stumble, ultimately the US stock market has forged higher providing the US economy and corporate earning remain strong.

“In fact, analysis of the eight peaks in the S&P 500 since 1971 suggest that the US interest rate needs to increase by 1.84% – or between seven and eight one-quarter point rate rises – before the market reaches its peak in the cycle.

“If the Fed follows through on its dot-plot and hikes rates twice more in 2017 and three times more in 2018, then the final increase next year will be the eighth of this upcycle, so next year could see monetary policy provide a key test of the nine-year-old bull run.”

S&P 500

peak level

Change in Fed Funds

cycle before S&P 500 peak

Change in Fed Funds cycle

before S&P 500 peak

Date

11-Jan-73

120

3.50% to 5.50%

2.00%

21-Sep-76

1,008

4.75% to 5.50%

0.75%

28-Nov-80

141

4.75% to 15.00%

10.25%

10-Oct-83

173

8.50% to 9.38%

0.88%

25-Aug-87

337

5.88% to 6.75%

0.88%

16-Jul-90

369

9.81% to 8.00%

-1.81%

24-Mar-00

1,527

4.75% to 6.00%

1.25%

09-Oct-07

1,565

3.75% to 4.25%

0.50%

Average

1.84%

Source: Thomson Reuters Datastream

2) Will the US Federal Reserve start to sterilise Quantitative Easing (QE) and reduce its $4.5 trillion balance sheet? And if so, what are the implications for US equity valuations?

“The Federal Open Markets Committee statement made no reference to this at all, so the issue remains in abeyance – probably to the delight of equity market bulls.

“Since the launch of QE-I in late 2008 the Fed has bought around $3.8 trillion of bonds of various shapes and kinds and there has been an apparently close correlation between the size of the Fed’s balance sheet and the S&P 500.

In theory, sterilising QE could see that reverse, unless strong earnings growth can take up the slack – so it is understandable that equities are rallying hard in the wake of an FOMC meeting where the issue does not appear to have arisen.”

“Even allowing for today’s retreat in the dollar, the consensus view on this is simple – the dollar will rise, especially if the Bank of Japan, Bank of England, European Central Bank and Swiss National Bank keep running their QE programmes and do not move to raise rates themselves.

“None of the quartet seems to be dashing to tighten policy. Although any move to do so could be the potential surprise that might stop the dollar in its tracks their current reticence does in theory point to dollar gains, as this chart going back to 1975 suggests, although the greenback did a very good job of ignoring the 2004 to 2007 rate tightening cycle.”

“The trade-weighted dollar index from the Bank of England still only stands at around 106 compared to the mid-1980s peak above 160 and the early 2000s one north of 120, so if it really starts to motor the buck could go further yet.

“Greenback gains to match those would be potentially worrisome for some asset classes.

“Emerging market equities in particular have tended to struggle when the dollar is strong, so another key test may face this asset class if the Fed keeps raising interest rates through 2017 and beyond.

“This explains why emerging markets are doing so well today, given the dollar weakness which has resulted from the Fed’s continued preference for careful baby steps rather than a sudden gallop higher in rates.”

“It is today, as dollar weakness is seeing metals and oil prices go higher, to the benefit of mining and oil stocks in particular, though a bigger challenge will come if the dollar starts to rise in response to steady Fed rate increases.

“Another reason why the dollar and emerging markets seem to make uneasy bedfellows is the US currency has also had an inverse relationship with commodity prices.

Source: Thomson Reuters Datastream, Bank of England

“While the past is by no means a guarantee for the future, this does make sense. With the exception of cocoa, commodities are priced in dollars, so a rising dollar makes it more expensive to buy them in local currency terms for non-dollar-pegged nations, potentially crimping demand. Today’s falling dollar will have the opposite effect.

“Commodities are a big export for many emerging markets (though not all, with India a glaring exception) so raw materials price weakness could again be a burden for some, notably Brazil, South Africa and Russia.”